Deck 10: Project Cash Flows and Risk

Question 1

Which of the following statements is true regarding a replacement decision?

A) The benefits resulting from the new investment is treated as an inflow.
B) The net cash flow from the sale of an old equipment is treated as an outflow at t = 0 (initial investment outlay).
C) The depreciation expenses on the new equipment is treated as an outflow.
D) Any loss on the sale of the old equipment is multiplied by the tax rate and is treated as an outflow at t = 0 (initial investment outlay).
E) An increase in the net working capital is treated as an inflow when the project begins (initial investment outlay) and as an outflow when the project ends (terminal cash flow).

Answer 1

A

Question 2

Which of the following statements is true about relevant cash flows?

A) Day-to-day operating cash flows of a project are relevant cash flows.
B) Inflation during the project's lifetime is a relevant cash flow.
C) Depreciation expenses not relevant cash flows to be considered in the cash flow of a project.
D) Sunk costs of engineering study to determine the feasibility of a project are relevant cash flows.
E) Opportunity cost of land being used for the project that the firm already owns is a relevant cash flow.

Answer 2

A

Question 3

Quantification of risk is difficult, and there are different types of risks like stand-alone risk, market risk and political risk. Sensitivity analysis is a good technique to measure market risk.

Answer 3

False

Question 4

A sunk cost is a cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected. These sunk costs are extremely important in capital budgeting decisions.

Question 5

Which of the following rules is essential for successful cash flow estimates, and ultimately, to successful capital budgeting?

A) The return on invested capital is the only relevant cash flow.
B) Only incremental cash flows are relevant to the accept/reject decision.
C) Total cash flows are relevant to capital budgeting analysis and the accept/reject decision.
D) Inflation is considered while estimating incremental cash flows.
E) Shipping and installation costs are included in cash flow estimation.

Question 6

Capital budgeting decisions must be based on the accounting income the project generates since stockholders are concerned with the reported net income the firm generates.

Question 7

According to the text, the financial staff's role in the forecasting process is to:

A) develop different assumptions for different departments.
B) make sure that no biases are inherent in the forecasts.
C) ensure that all the costs like sunk costs are included in the forecasting.
D) set the sales price and coordinating marketing schemes for use by other departments.
E) provide a rough estimate of cash flows as sophisticated techniques are available to check their accuracy.

Question 8

One problem with Monte Carlo simulation analysis is that while the simulation may provide some insights into the riskiness of a project, the analysis does not lead to a clear-cut accept versus reject decision.

Question 9

When evaluating a new project, a firm should consider _____, as an incremental cash flow occurs only at the start of a project's life.

A) initial investment outlay
B) feasibility study cost
C) sunk costs
D) opportunity costs
E) externalities

Question 10

Which of the following is an incremental cash flow?

A) Market research costs
B) Change in working capital
C) Sunk costs
D) Opportunity costs
E) Externalities

Question 11

Hill Top Lumber Company is considering building a sawmill in the state of Washington because the company doesn't have such a facility to service its growing customer base that is located on the west coast. Hill Top's executives believe that future growth in west coast customers will make the sawmill project a good investment. When evaluating the acceptability of the project, which of the following would be considered a relevant cash flow that should be included when determining its initial investment outlay?

A) Hill Top spent $150,000 to prepare the feasibility report of the project.
B) The cost of the project, $2 million, if invested in existing projects could have provided a return of $3.5milion
C) The expected inflation during the project's life is 3%.
D) It will cost $3 million to clear the land on which Hill Top wants to build the sawmill.
E) It is estimated that $20 million of business from existing customers will move to the new sawmill.

Question 12

A key difference between a replacement project analysis and an expansion project analysis is that only the expansion project uses the net present value (NPV) method for project evaluation.

Question 13

If a firm is considering purchasing an asset whose beta is greater than the current beta of the firm, it should use a discount rate greater than the firm's average required rate of return to evaluate the possible investment.

Question 14

When evaluating the cash flows associated with a capital budgeting project, shipping and installation costs associated with the purchase of an asset, such as a lathe, are considered part of the:

A) initial investment outlay because these expenses are effectively part of the asset's purchase price.
B) incremental operating cash flows because shipping and installation costs represent expenses that have to be written off over the life of the asset.
C) terminal cash flows, because these expenses aren't paid until the end of the asset's life.
D) sunk costs because these expenses do not affect any current or future cash flows associated with investing in the asset.
E) opportunity cost of the project because these costs are increasing the potential of the project.

Question 15

Which of the following items is considered when computing the terminal cash flow for an expansion project?

A) Change in net working capital.
B) Inflation during the project's life.
C) Book value of the asset.
D) Opportunity cost of the project.
E) Sunk cost of the project.

Question 16

If an asset being considered for acquisition has a beta of zero, its expected return will be equal to the risk-free rate.

Question 17

When a particular project might have very uncertain cash flows, the Monte Carlo simulation technique can be used to measure the net present value (NPV) of the cash flows to understand the outcomes for worst case scenario and best case scenario.

Question 18

Depreciation must be considered when evaluating the incremental operating cash flows associated with a capital budgeting project because:

A) it represents a tax-deductible cash expense.
B) the firm has a cash outflow equal to the depreciation expense each year.
C) depreciation has an impact on the taxes paid by the firm, which is a cash flow.
D) depreciation is a sunk cost.
E) depreciation is a cash flow that doesn't change.

Question 19

Which of the following statements concerning cash flow evaluation in capital budgeting is correct?

A) When determining a project's terminal cash flows, it is generally assumed that the firm's operations do not return to the same level as they were before the project was purchased.
B) Any change in depreciation expense must be computed as it affects the cash flow of a project.
C) The relevant marginal cash flows associated with a project should always include depreciation, because depreciation is an annual operating expense that requires a cash payment.
D) If an asset is depreciated using the Modified Accelerated Cost Recovery System (MACRS), its depreciable basis is the amount that can be depreciated over the asset's useful life, which generally includes the purchase price minus any shipping and installation charges or other costs that are incurred in order to prepare the asset for use.
E) The sunk costs associated with an investment proposal are relevant cash flows for capital budgeting analysis, so they should not be included in the computation of the marginal cash flows.

Question 20

Which of the following statements is true while considering an expansion project?

A) Depreciation expenses will be deducted from the net income to calculate supplemental operating cash flows.
B) The expansion project will be accepted if the net cash flows are negative.
C) Shipping and installation costs associated with preparing the machine to be used to produce the new product will be part of the initial outlay.
D) The cost of a product analysis completed in the previous tax year and specific to the new product will be included in the calculation of initial outlay.
E) Inflation rates during the new project's life will be incorporated in the cash flows.

Question 21

Risk in a revenue-producing project can best be adjusted for by:

A) ignoring it.
B) adjusting the discount rate upward for increasing risk.
C) adjusting the discount rate downward for increasing risk.
D) Picking a risk factor equal to the average discount rate.
E) reducing the NPV by 10 percent for risky projects.

Question 22

Which of the following methods involves calculating an average beta for firms in a similar business and then applying that beta to determine the beta of its own project?

A) Sensitivity Analysis
B) Pure play method
C) Accounting beta method
D) Capital asset pricing model (CAPM) method
E) Net present value (NPV) analysis

Question 23

Topsider Inc. is considering the purchase of a new leather-cutting machine to replace an existing machine that has zero salvage value. The net salvage value of the new machine is $6,000 and the return of net working capital is $3,520. Which of the following is the terminal cash value of the new machine?

A) $6,000
B) $3,520
C) $9,520
D) $7,000
E) $3,000

Question 24

Which of the following is used in analyzing systematic risk?

A) Sensitivity analysis
B) Net present value
C) Beta
D) Monte Carlo simulation
E) Depreciation

Question 25

Chovita Sports Company evaluated a project as a low-risk project. Chovita generally evaluates projects that are less risky than average by adjusting its required rate of return by 2 percent. If Chovita expects 12% return on average risk projects, then it should expect a return of _____ for a less-risky project.

A) 8%
B) 12%
C) 16%
D) 10%
E) 48%

Question 26

Chovita Motors Corp. is considering a machine that costs $100,000 that will increase the net income of the company. The net income for the next 3 years is expected to be $30,000, $90,000, and $150,000. The depreciation expense for the next 3 years will be $5,000, $3,000, and $2,000. If the machine has no salvage value and then net present value (NPV) of the project is _____. The expected rate of return is 10%. (Round off the answer to nearest units place.)

A) $151,669
B) $175,600
C) $369,996
D) $122,878
E) $250,614

Question 27

The Monte Carlo simulation:

A) can be useful for estimating a project's market risk.
B) uses probability distributions for variables as input data to estimate the project's net present value (NPV).
C) produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR for different scenarios.
D) gives the exact outcome that can be expected from a project.
E) calculates NPV for a change in one key variable.

Question 28

Tech Engineering Company is considering the purchase of a new machine to replace an existing one. The current market value of the old machine is $14,000 and its book value is $5,000. The new machine's cost is $30,000. If the tax rate is 40%, the initial investment outlay for the new machine is _____.

A) $24,600
B) $30,000
C) $14,000
D) $16,000
E) $36,000

Question 29

Which of the following statements is correct?

A) If a firm's stockholders are well diversified, we know from theory and from studies of market behavior that corporate risk is not important.
B) Undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than market risk.
C) Empirical studies of the determinants of required rates of return (k) have found that only market risk affects stock prices.
D) Market risk is important but does not have a direct effect on stock price because it only affects beta.
E) Market risk does not play any role in determining the rate of return on an investment.

Question 30

A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision maker should:

A) decrease the internal rate of return (IRR) of the asset to reflect the greater risk.
B) decrease the net present value NPV of the asset to reflect the greater risk.
C) reject the asset, since its acceptance would increase the risk of the firm.
D) ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm.
E) increase the required rate of return from the project to reflect the higher risk of the project.

Question 31

Which of the following statements is correct?

A) A relatively risky future cash outflow should be evaluated using a relatively high discount rate.
B) If a firm's managers want to maximize the value of the stock, they should concentrate exclusively on the projects' market, or beta, risk.
C) If a firm evaluates all projects using the same required rate of return to determine NPVs, then the riskiness of the firm as measured by its beta will probably decline over time.
D) If a firm has a beta that is less than 1.0, say 0.9, this would suggest that its assets' returns are negatively correlated with the returns of most other firms' assets.
E) Project risk estimation is independent of the beta coefficient.

Question 32

Ziker Golf Company evaluated a project as a risky project. Ziker generally evaluates projects that are riskier than average by adjusting its required rate of return by 4 percent. If Ziker expects 12% return on average risk projects, then it should expect a return of _____ for a risky project.

A) 8%
B) 12%
C) 16%
D) 10%
E) 48%

Question 33

Zinc Corp is planning to purchase new machinery. The initial cash outlay is expected to be $40,000 and the expected return on investment is 9%. The cash flows for the next 3 years are $9,800, $11,720 and $9,640. Based on net present value (NPV) analysis, Zinc Corp should:

A) accept the project as the NPV is $14,500.
B) reject the project as the NPV is $(13,700.84).
C) accept the project as the NPV is (28,900.25).
D) reject the project as the NPV is 40,500.
E) accept the project as the NPV is $56.225.

Question 34

A project with more corporate risk than average will also have:

A) less political risk.
B) more beta risk.
C) less project risk.
D) less exchange rate risk.
E) less depreciation risk

Question 35

A firm is evaluating a new machine to replace an existing, older machine. The change in depreciation is $3,000. The firm's marginal tax rate is 30 percent. Which of the following statements is true?

A) Depreciation does not affect the calculation of the supplemental operating cash flow.
B) Depreciation is added to the net income to calculate the supplemental operating cash flow.
C) Depreciation expense is added to the initial outlay incurred to purchase an asset.
D) Depreciation is deducted from the terminal cash flows from an asset.
E) Depreciation is included in capital budgeting only if it exceeds the tax expense of an asset.

Question 36

If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions concerning the relationship between risk and return are true, then which of the following should be true?

A) If the beta of the asset is larger than the firm's beta, then the required return on the asset is less than the required return on the firm.
B) If the beta of the asset is smaller than the firm's beta, then the required return on the asset is greater than the required return on the firm.
C) If the beta of the asset is greater than the corporate beta prior to the addition of that asset, then the corporate beta after the purchase of the asset will be smaller than the original corporate beta.
D) If the beta of an asset is larger than the corporate beta prior to the addition of that asset, then the required return on the firm will be greater after the purchase of that asset than prior to its purchase.
E) If the beta of an asset is larger than the firm's beta, then the required rate of return is equal to the beta.

Question 37

Which of the following statements is correct?

A) Sensitivity analysis is incomplete because it fails to consider the range of likely values of key variables as reflected in their probability distributions.
B) In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable, such as unit sales, would produce only a small error in the project's net present value (NPV).
C) The primary advantage of simulation is that it provides a very accurate point estimate of a project's NPV.
D) One important benefit of simulation analysis as compared to scenario analysis is that once the analysis is complete, it provides a clear accept/reject decision rule.
E) Simulation considers only discrete outcomes for a project.

Question 38

Stanton Inc. is considering the purchase of a new machine, which will reduce manufacturing costs by $5,000 annually and increase earnings before depreciation and taxes by $6,000 annually. Stanton will use the MACRS method to depreciate the machine, and it has estimated the depreciation expense for the first year as $8,000. Which of the following is the supplemental operating cash flow for the first year if Stanton's marginal tax rate is 40 percent?

A) $15,000
B) $23,000
C) $40,000
D) $9,800
E) $4,500

Question 39

Trust Engineering Company is considering the purchase of a new machine to replace an existing one. The old machine was purchased 5 years ago at a cost of $20,000, and it is being depreciated on a straight line basis to a zero salvage value over a 10-year life. The current market value of the old machine is $14,000. The new machine, which falls into the MACRS 5-year class, has an estimated life of 5 years, it costs $30,000. The change in depreciation expense to be considered while capital budgeting for this machine is _____. The MACRS rates for 5-year class are Year 1-20%, Year 2-32%, Year 3-19%, Year4-12%, Year 5-11%, Year 6-6%.

A) $10,500
B) $23,400
C) $44,000
D) $20,000
E) $17,000

Question 40

Triblaze Corp. is considering buying a new truck. The cost of the truck is $62,000 and the expected cash flows for the next 3 years due to savings from the new truck are $19,920, $22,800, and $31,280. The net present value (NPV) of the truck is ____ if the company's expected rate of return is 10%.

A) $5,600
B) $(2,200.75)
C) $30,000
D) $(1,546.81)
E) $2,500

Question 41

The process of sending cash flows from a foreign subsidiary back to the parent company is known as _____.

A) net present value analysis
B) Monte Carlo simulation
C) pure play method
D) capital allocation
E) repatriation of earnings

Question 42

_____ is the risk of expropriation (seizure) of a foreign subsidiary's assets by the host country.

A) Pure play risk
B) Political risk
C) Beta risk
D) Exchange rate risk
E) Market risk

Question 43

Klott Company used scenario analysis and estimated its expected net present value (NPV) as $10,300 and expected standard deviation (σ) as $12,083. The coefficient of variation (CVNPV) of Klott's NPV is _____.

A) 0.25
B) 1.2
C) 5.6
D) 1.17
E) 0.45

Question 44

One of the differences between capital budgeting for domestic and foreign operations is that the:

A) cash flow estimation is simple for foreign operations.
B) repatriation of earnings does not occur for foreign operations.
C) cash flows for foreign operations are subject to future exchange rate changes.
D) foreign operations are free from taxes imposed by home-country and host-country.
E) foreign operations are always less riskier than domestic operations.

Question 45

Carolina Insurance Company, an all-equity life insurance firm, is considering the purchase of a fire insurance company. The fire insurance company is expected to generate a return of 20 percent with a beta of 2.5. If the risk-free rate is 8 percent and the market risk premium is 6 percent, the expected return from the insurance company is _____.

A) 10%
B) 23%
C) 14%
D) 29%
E) 8%

Question 46

If the risk-free rate is 6 percent, the return on an average stock is 10 percent, and the beta of this project is 1.50, then the expected return from the project is _____.

A) 12%
B) 24%
C) 4%
D) 19%
E) 23%

Question 47

Sun State currently has a required rate of return of 18 percent, U.S. Treasury bonds yield 7 percent, and the market risk premium is 5 percent. Which of the following is the value of the beta?

A) 1.64
B) 2.20
C) 0.91
D) 2.98
E) 0.14

Question 48

_____ is the uncertainty associated with the price at which the currency from one country can be converted into the currency of another country.

A) Pure play risk
B) Political risk
C) Beta risk
D) Exchange rate risk
E) Market risk

Question 49

Investing in foreign subsidiaries can be less risky when:

A) laws to repatriate earnings are complex.
B) the host country has higher tax rates.
C) the host country is politically unstable.
D) the exchange rates are volatile.
E) there is international diversification.

Question 50

Companies can reduce loss from expropriation:

A) by expecting low returns from high risk foreign subsidiaries.
B) by establishing foreign subsidiaries in countries with volatile exchange rates.
C) by financing the foreign subsidiary using foreign currencies.
D) by obtaining insurance against economic losses from expropriation.
E) by investing all the funds in one foreign subsidiary.